A Matter of Disclosure

The wheels of justice may turn slowly, but they do turn. It has been more
than three and a half years since the 2008 financial crisis saw the implosion of
two Oppenheimer bond funds. The managers of both Oppenheimer
Core BondOPIGX and
Oppenheimer Champion Income OPCHX had made large bets on a slice of the commercial
mortgage-backed securities market by purchasing so-called total return swaps for
the portfolios. That bet effectively added leverage to the funds, and each
sustained massive losses when the CMBS market tanked in 2008. We took an
in-depth look at what happened back then, and one of our chief concerns was
that Oppenheimer had done very little in its marketing and regulatory materials
to explain just how much risk its portfolios had been taking.

Notably, though, the SEC also knocked the firm for failing to adequately
disclose the Champion Income fund's use of leverage. In particular, the agency
noted that the fund's prospectus disclosed that it invested in swaps and other
derivatives, but it did not "adequately disclose that Champion could use
derivatives to such an extent that the fund's total investment exposure could
exceed the value of its portfolio securities and its investment returns could
depend primarily upon the performance of bonds that it did not own."

Of course, it's not clear that a line mentioning leverage in the fund's
prospectus would have made much of a difference for investors. In fact, the SEC
mentioned the omission only with regard to Champion Income, presumably because
Core Bond's prospectus included a section on derivatives that stated they could
generate leverage. It seems likely that if Oppenheimer had thought to include
the same section in the prospectus for Champion Income, the firm could have
avoided at least one element of the SEC's complaint.

The entire affair, however, is a reminder of just how much more many
companies could do to better inform their investors. The good news is that many
prospectuses at least mention derivatives and leverage today. We took a look at
filings for several of the largest bond funds, for example, and found that
almost every prospectus contained language explaining something about the
potential risk that their use of derivatives could produce leverage. It's
boilerplate stuff that most people gloss over, but at least it's there. And in
general, it seems that there are some fund companies at least making more of an
effort to inform their investors. We took a look at a handful of them in a recent
column.

What we don't often see, however, is much--or any--mention of leverage or
derivatives in funds' periodic portfolio reports, fact sheets, or marketing
materials. Of course, most fund companies don't want to write anything that they
think will spook investors, and there are certainly valid uses for derivatives
that don't dramatically increase funds' risk profiles. Even in such cases,
though, it's disturbing to look at funds that make generous use of derivatives
but that choose not to explain them. In the grand scheme, a little more text
isn't going to stop fund managers from making mistakes, but it could go a long
way toward making sure that investors better understand the potential risks of
what they own.